An Introduction to Inheritance Tax (IHT) and Life Insurance

‍What is Inheritance Tax?

Inheritance tax (IHT) is a levy on the estate (property, money and possessions) of someone who has passed away. IHT is applied at a rate of 40% on the portion of an estate that exceeds a certain threshold, commonly known as the nil-rate band.

Nil-Rate Band and Additional Thresholds

The standard nil-rate band stands at £325,000. This means that no inheritance tax is paid on the first £325,000 of a deceased individual’s estate. Any value above this amount is taxed at 40%. However, there are some additional allowances that are available in certain circumstances:

• Residence Nil-Rate Band (RNRB): Homeowners passing on their principal private residence to direct descendants (children or grandchildren) benefit from an extra allowance of £175,000, which effectively increases an individual’s nil-rate band to £500,000 when pass on their home.

• Transfers between Spouses or Civil Partners: Transfers of assets between spouses or civil partners are exempt from IHT. Upon the death of the second partner, their combined nil-rate band can be used, allowing for a threshold of up to £1 million if they own a qualifying residence or £650,000 otherwise, so long as the total value of the estate does not exceed £2,000,000. The combined nil-rate residence band goes back to £650,000, however, if the value of the estate exceeds £2,000,000.

A significant change introduced in the Autumn 2024 budget is that, with effect from 6 April 2027, a deceased’s pension fund will become part of their estate for inheritance tax purposes, whereas this was previously exempt. Furthermore, if the deceased was over 75 at the time of their death, the pension fund would not only attract IHT, but also income tax at the marginal tax rate of the inheritor. Effective 6 April 2026, businesses and farms which currently qualify for exemption from IHT will also be brought into the ambit of IHT, over time, if their value exceeds certain thresholds. Previously exempt unquoted shares, if held for a certain period, will also be brought into the ambit of IHT.  

The Role of Life Insurance in Estate Planning

One strategy to cover potential inheritance tax is to take out life insurance for the benefit of the inheritors. Payouts from life insurance policies can provide a lump sum to the beneficiaries after the policyholder’s death which can be used to pay the IHT due on the estate. This approach ensures that heirs are not forced to sell property or other assets to cover the IHT liability.

How Does Life Insurance Help With IHT?

When structured correctly, life insurance can be an effective tool for estate planning:

1. Life Insurance in Trust: If a life insurance policy is placed “in trust” for the beneficiaries, the payout from the policy is not considered part of the estate and is therefore not subject to IHT. Life policy payouts are thus available to inheritors to pay IHT, relieving them from financial stress during probate.

2. Direct Payouts to Beneficiaries: If the life insurance policy is not placed in trust, the payout is included in the estate's total value, which may increase the IHT liability. Therefore, most financial advisers recommend using a trust structure.

Types of Life Insurance for IHT Planning

There are several types of life insurance policy that can help with inheritance tax planning:

• Whole-of-Life Insurance: This policy guarantees a payout whenever the policyholder dies, making it suitable for covering IHT. Premiums can be higher than term insurance but offer lifetime cover.

• Term Life Insurance: This policy covers a defined period and is usually not suitable for IHT planning purposes, unless it coincides with a specific financial obligation that ends before death, such as a mortgage loan repayment date.

Maximising Estate Planning with Life Insurance

In addition to life insurance, there are various estate planning strategies to help optimise inheritance tax. Combining these methods with life insurance can offer wider protection.

1. Gifting During Lifetime

One common strategy is to reduce the size of your taxable estate by gifting assets during your lifetime. There is an annual exemption for gifts up to £3,000 per year, and larger gifts may also fall outside the estate if the donor survives for seven years after making the gift (known as the 7-year rule). You can also assist you children or grandchildren with expenses such as rent without the gift being subject to IHT if the gift is demonstrably from your excess income, i.e. you do not need that income to live on comfortably.

2. Use of Trusts

Trusts can also be used to protect assets from inheritance tax. By placing assets into a trust, they may no longer count as part of the estate for IHT purposes, although complex rules apply and professional advice is often required.

Conclusion

Inheritance tax can significantly reduce the value of the estate passed on to loved ones, but life insurance offers a means to cover this liability. By placing a policy in trust and using other estate planning strategies, individuals can minimise the impact of IHT. Given the complexity of the tax system and the potential savings, professional advice is highly recommended when setting up life insurance and other strategies for IHT purposes.

FAQs:

Q. What is the current threshold for Inheritance Tax (IHT)?
A. The standard nil-rate band for IHT is £325,000 for each individual. This means no inheritance tax is paid on the first £325,000 of an individual’s estate. The residence nil-rate band is £500,000 as long as the value of the estate does not exceed £2,000,000. For estates exceeding the nil-rate band, the tax rate is 40% on the portion that exceeds the threshold. If pension funds form part of the estate, in addition to IHT, they are also subject to income tax at the marginal tax rate of the inheritor if the deceased was over 75 at the time of their death. As there is no IHT on transfers between spouses or civil partners, a deceased partner’s unused nil-rate band and residence nil-rate band can be combined. This means no inheritance tax is paid on the first £650,000 of an individual’s combined estate. The combined residence nil-rate band is £1,000,000 as long as the total value of the estate does not exceed £2,000,000. Otherwise, it is £650,000.

Q. What is the Residence Nil-Rate Band (RNRB) and how does it work?
A. The RNRB is an additional allowance of £175,000, available when someone passes on their principal private residence to direct descendants (children or grandchildren). In this situation, the nil-rate band increases to £500,000, so long as the value of the estate does not exceed £2,000,000. An increase in the nil-rate band reduces the amount of an estate that is subject to IHT. A deceased partner’s unused nil-rate band can be combined with an individual’s nil-rate band.

Q. Are transfers between spouses or civil partners subject to IHT?
A. No, transfers between spouses or civil partners are exempt from IHT. When the second partner passes away, their unused nil-rate band and residence nil-rate band can be combined.

Q. How can life insurance help cover inheritance tax?
A. Life insurance can be used to cover IHT by providing a lump sum payment to inheritor beneficiaries. If placed in trust, the insurance payout is not counted as part of the estate and can potentially help beneficiaries pay IHT without having to sell assets like property.

Q. What is the 7-year rule in inheritance tax planning?
A. The 7-year rule applies to gifts made during an individual’s lifetime. If the donor survives for seven years after making a gift, that amount will not be included in their estate for IHT purposes. Gifts made less than seven years before death may be subject to tax, with the amount of tax due calculated on the basis of a sliding scale dependent on the time elapsed since the gift was made.

Q. What types of life insurance are best suited for IHT planning?
A. Whole-of-life insurance is often recommended for IHT planning as it guarantees a payout whenever the policyholder dies. Term life insurance, on the other hand, may be useful if aligned with a specific financial obligation such as mortgage repayment.

Sources:

How Inheritance Tax works: thresholds, rules and allowances | Gov.uk